Download a) Explain why negative externalities are an example of market

a) Explain why negative externalities are an example of market failure
Real world markets aren’t perfect, meaning they are not allocatively efficient. When
producers and consumers meet in the market place the quantities they purchase at
each price do not always represent an ideal allocation of resources, thus market
failures are created. In addition to the private cost and private benefit associated
with product, that is the cost to the producer of producing the good and the utility
gained by the consumer through consuming it, there are additional costs and
benefits, positive and negative, that come along the production and consumption of
certain good. Negative externalities are shown by products where either the
marginal cost to society (MSC) is larger than the marginal cost to producers (MPC),
or where the marginal private benefit (MPB) is greater than the marginal social
benefit (MSB). For example, the consumption of cigarettes has a negative externality
of consumption. While they may provide the actual consumer with a certain utility,
the smoke produce harms others, thus the MSB is lower than the MPC. This is shown
in the diagram below. Here I would include Diagram 12.5 on page 144.
As seen on the diagram the negative externality causes the product to be overconsumed. The social optimum level would be Q*, however Q1 is consumed leading
to a welfare loss indicated by the shaded triangle. This welfare loss is representative
of a market failure. The same can be seen for negative externalities of production,
where the MPC is lower than the MPS. Once again welfare loss is created due to
over-production of the good, causing a market failure.
b) Evaluate three policies that governments might implement to reduce negative
externalities associated with the environment.
Externalities exist because the market equilibrium formed by the market is not
allocatively efficient and thus causes a dead welfare. In order to fix this the
government has to make MPB equal to MSB (or MPC = to MSC) by shifting the
corresponding demand and supply curves. The main externality involving the
environment is pollution that firms produce while manufacturing goods. These
pollutants heat up the atmosphere, leading to global warming and sea level rise,
causing huge negative externalities.
One approach the gov’t could use here are taxes. By placing an indirect tax on firms
they are effectively increasing the firms cost, thus pushing up MPC until it matches
the MSC. This is shown in the diagram below. Here I would include diagram 12.3 on
page 142, although I would make the tax equal to the whole externality. Although
these taxes will eliminate the externality’s effect on the market there are problems
associated with it. It is very difficult to put a price on pollution, so chances are the
gov’t will set the tax at the wrong level and the welfare loss will only be partially
eliminated. Also, in the end this taxation doesn’t really solve the problem. Although
less quantity is produced now, Q* rather than Q1, the firms still pollute at high
levels.
Another method the government could employ are tradable emission permits.
These are allocated to firms by the gov’t and allow each firm to pollute up to an
extend. It’s in the firm’s best interest to pollute as little as possible now, because if
they have permits left over they can sell them to other firms that require them, thus
increasing their profit level. For example, the production of CFCs in the United
States is controlled in this way. Once again the problem exists that once the permits
are set pollution levels won’t fall, all the permits will most likely be used up by
someone in the market, so although this is another way of making polluters pay, the
externality itself persists. It is also difficult for a government to set the right level
and to fairly allocate the permits, potentially leading to disputes.
Instead of punishing firms for polluting the gov’t could instead encourage them to
invest into cleaner technologies. This can be done by subsidizing the development of
these, thus lowering the firms cost of it. This can be seen on the diagram below. Here
I would include Diagram 12.9 from page 151. By lowering the cost of the producer
the gov’t pushes down the supply curve from S1 to S1+subsidy, thus increasing the
quantity of electricity while lowering it’s price. In this way resources are reallocated
away from carbon based fuels and towards green energy, thus eliminating or at least
reducing the externality. However, this will come with large expense to the
government, unlike with the previous two methods where they actually make
money. There is a large opportunity cost involved as this money could also be spent
on other objectives, such as healthcare or education.
In conclusion there are several ways a gov’t can eliminate the externality, although
some of the ways only make producers pay for it while others actually help the
environment. The only real way to help the environment in the long run without
hurting the economy (banning producing would increase unemployment) is to
invest into green energy, a very costly process. It is thus only possible for gov’t of
developed countries and will still take a long time. In the short run it might me
favourable for gov’t to employ methods that will earn them a profit, especially in the
developing countries, but in the long term this money should be used to reduce the
dependence on fossil fuels to save the environment.